Keppel Infrastructure Trust - Look Beyond Basslink Irritant

We believe KIT is sufficiently ring-fenced from possible legal penalties at Basslink.

Maintain BUY with Target Price of S$0.60.

High dividend visibility remains; maintain BUY.

Keppel Infrastructure Trust (KIT) maintained its record of steady DPU of 0.93 Scts in 1Q18, as expected. KIT generated distributable cash flow of S$36.2m in 1Q18, in line with expectations.

Most of KIT’s assets derive revenue from availability-based payments, independent of actual offtake. Hence, cash flows are highly predictable and not exposed to economic cycles.

Concession agreements are long term in nature, of up to 20 years, and mostly with government entities, thereby minimising risk.

Where We Differ:

We believe the Trust is sufficiently protected from ongoing troubles at Basslink, where the State of Tasmania is demanding indemnification to the tune of over A$100m for losses incurred during the Basslink outage in 2016.

While Basslink maintains the cable failure was a force majeure event and will vigorously defend its claim in court, if required, even in the worst case scenario, KIT will not be liable to pay any damages as any claims against Basslink are ring-fenced at Basslink level.

In any case, KIT does not depend on cash flows from Basslink for current distributions, and project loans are also non-recourse to KIT. We ascribe zero value to Basslink in our valuations for KIT, hence the negative newsflow from Basslink is an irritant at best and does not affect fundamentals for KIT.

Potential catalyst.

We look forward to the Trust kicking off its M&A ambitions in the near-to-medium term.

Valuation

Based on our DDM-based valuation methodology (cost of equity: 5.5%), we derive a valuation of S$0.60 for KIT.

The Trust is currently trading at a healthy yield of 7%, and provides a good entry point for investors, following the recent de-rating owing to negative newsflow emanating from Basslink asset.

Key Risks to Our View

Key risks include

plants not meeting availability thresholds owing to operating issues,

increasing debt refinancing risks for the asset portfolio as the assets age, and

1Q18 distribution of 0.93 Scts in line.

Group revenue was up 3% y-o-y and 1% q-o-q to S$160m in 1Q18 and distributable cashflows – the key number for KIT – were up 6% y-o-y and 18% q-o-q to S$36.2m. This is slightly higher than quarterly distribution of S$35.9m (0.93 Scts per share) and hence demonstrates sustainability of distributions. This was mainly due to better performance from City Gas, owing to adjustment of gas tariffs in response to higher underlying fuel prices. Cash flows from other key assets remained stable.

Basslink continued to generate positive funds from operations, but the Trust does not use these cash flows for distribution purposes, rather for servicing loans.

Meanwhile, dispute between Basslink and counterparties has intensified.

KIT's wholly-owned subsidiary Basslink Pty Ltd (Basslink) has received a letter from the State of Tasmania alleging that it had breached the Basslink Operations Agreement (BOA).

The BOA governs the contractual relationship between the State and Basslink as the operator of the Basslink Interconnector. The State has alleged that warranties about the design and construction of the Basslink Interconnector were breached, leading to the six-month outage in 2016.

The State has also alleged that it has suffered various losses and that Basslink must indemnify it for those losses (including alleged losses incurred by Hydro Tasmania arising from the cable failure in December 2015), amounting to over A$100m.

Basslink will vigorously defend its position.

Basslink understands that the State's allegations stem from the DNV GL reports commissioned by the lawyers for Hydro Tasmania, which were provided to Basslink in December 2017. Basslink has previously noted that DNV GL did not conduct any testing of the Basslink Interconnector's cable and their reports were solely based on theoretical modeling, which has not been shared with Basslink.

Basslink continues to stand by the independent investigation that was undertaken by independent cable expert, Cable Consulting International (CCI), who concluded the actual root cause of the cable failure in December 2015 as “cause unknown”, and hence, Basslink maintains the cable failure as a force majeure event. Thus, Basslink denies that it is liable for any losses incurred by the State and should the State take these allegations further, Basslink will vigorously defend its position during any possible arbitration proceedings if the dispute is not resolved otherwise.

Long legal battle likely, Basslink sale process on the backburner.

Both parties seem unwilling to accept each other's investigations at this point of time and a long legal process seems likely at this point. The most immediate fallout of this is that the sales process initiated by KIT management for the Basslink asset is likely to be derailed indefinitely, pending an outcome of any legal challenge. We view this as a negative development, as a sale of Basslink would have removed a key sentiment overhang for the stock.

In a separate development, Basslink Interconnector is down again for a couple of months.

On 28 March 2018, Basslink announced that a third-party contractor damaged a piece of equipment during routine maintenance works which resulted in a service outage. There is no damage to the cable itself. The repair requires specialised expertise and equipment from overseas and Basslink is working to return the interconnector to service.

Based on the latest available information, the anticipated return to service date is 31 May 2018. This event is unrelated to the Incident and the ongoing dispute with the State of Tasmania. This will likely again cause some loss of revenue and adds to the negative newsflow surrounding the asset.

KIT is sufficiently ring-fenced from troubles at Basslink.

We believe the Trust is sufficiently protected from ongoing issues at Basslink. Even in the worst-case scenario, KIT will not be liable to pay any damages as any claims against Basslink are ring-fenced at Basslink level. In any case, KIT does not depend on cash flows from Basslink for current distributions, and project loans are also non-recourse to KIT. We ascribe zero value to Basslink in our valuations for KIT, hence the negative newsflow from Basslink is an irritant at best and does not affect fundamentals for KIT.

Maintain BUY with Target Price of S$0.60.

Based on our DDM-based valuation methodology (Cost of Equity – 5.5%), we derive a valuation of S$0.60 for KIT.

The Trust is currently trading at a healthy yield of 7% based on annual distribution forecast of 3.72 Scts in FY18, and provides a better entry point for investors following recent de-rating owing to negative newsflow from Basslink asset.

Acquisitions the key future catalyst.

Apart from the ROFR pipeline, management continues to evaluate third-party options in sectors like energy, telecoms, water and waste management. We look forward to the Trust kicking off its M&A ambitions in the next 6-12 months. This should be a key catalyst for further re-rating

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